BBVA proposes VAT, income tax strategy as Mexico debates reform

With a variety of proposals to overhaul Mexico’s tax system now surfacing in congress, BBVA Research outlined both the limitations and opportunities of tax collection, mainly focusing on value-added tax (VAT) and income tax provisions.

In a report, the research unit of Mexico’s largest commercial bank said tax revenues represented only 16.2% of Mexican GDP, putting it at the bottom end of a ranking for tax collection rates in OECD countries (see graphic below), while also having one of the lowest rates in Latin America. 

Changes to either regime is likely to be contentious as with any tax reform effort; however, the administration of President Andrés Manuel López Obrador (AMLO) is likely to target higher taxes on large businesses and corporations.

Source: BBVA Research and OECD

BBVA Research recommends a refocus looking at how certain ostensibly pro-working class aspects of the tax framework are actually regressive or underperforming.

“Boosting VAT tax revenues requires the elimination of the zero rate regime for many items with the exception of some foods and would be justified by taxation being regressive,” wrote BBVA Research, who added that any adjustment should “be accompanied by a strengthening of social safety nets.”

Under the existing framework, the VAT regime, known in Mexico as IVA, sets a sales tax of 16% on most products nationwide with exceptions for the northern and southern borders, generating 3.9% of GDP in tax revenue, according to BBVA Research. 

The income tax regime (ISR) generates 3.4% of GDP and IVA and ISR collections are both well below the OECD average of 7.1% and 8.3%, respectively.

The only item that showed a higher collection in Mexico than the OECD average (3.3%) was the corporate tax with 3.7%.

Food and medicine are exempt from IVA, but this has the unintended effect of being regressive with the poorest actually gaining the least from the current zero-IVA policies.

“In general, generalized subsidies tend to be regressive,” said BBVA Research, “Boosting VAT tax revenues requires the elimination of the zero rate regime for many items with the exception of some foods and would be justified by the regressive taxation.” 

A wide variety of foods are not consumed by lower-income families and as such generate no VAT, while processed and prepared food tend to be consumed by wealthier households, enjoying the exemption though not necessarily needing it, according to the research unit.

“According to the 2020 fiscal expenditure budget, the zero rate on food is regressive since the tenth and first deciles of income receive 14.1% and 3.8% of the total benefit, respectively,” said BBVA Research. 

In the case of drugs, the zero rate is even more regressive since these deciles receive 27.7% and 3.1%, respectively, it added.

This is detailed in the following graphics showing the tax benefit distribution for food and medicine exemptions by decile of income.

Source: BBVA

The VAT exemption could be eliminated for most foods with the exception of a basket of basic food staples – and the amount collected could help create support programs aimed at the lowest income levels, according to BBVA Research.  

It also said that current legislative proposals need to take this and other key issues related to VAT into consideration to reach a comprehensive solution. 

 “It is important to mention that the relative low level in the tax collection efficiency ratio for VAT in Mexico (29%) vs. the average for Latin America (50%) is mainly due to two factors: 1) a relatively low tax base due to tax expenditures and informality; and 2) high non-compliance.”

Raising revenue

Taking all of the above factors into the legislation, “a comprehensive strategy to attack VAT evasion could represent 0.5% of GDP in additional collection,” read the report.

Such a strategy also requires simplification of the regime for small taxpayers and the expansion of the coverage of audits for…